3 Reasons Municipal Bonds Belong in Your Portfolio

When people hear the word "bonds," they often think of the debt issued by large corporations looking for a way to raise money. But the world of bond investing extends far beyond corporate bonds. There are also municipal bonds, or munis, which offer countless investment opportunities.

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Muni bonds are debt instruments issued by different localities, and there are two primary types: general obligation and revenue. General obligation bonds are issued to cover projects that don't have defined revenue streams. They're backed by the full faith and credit of the issuing entities, which means the municipalities are required to do whatever it takes to repay them on schedule. There are also revenue bonds, which are backed by specified sources of income. A city might issue a revenue bond to build a bridge and then use the proceeds from toll collections to repay bondholders.

Though there are far more corporate bonds available to invest in than municipal bonds, the muni bond market, at $3.7 trillion, is still going strong. Here are three reasons to consider getting in on the action.

1. Tax-free interestWhen you invest in corporate bonds, the interest payments you receive are subject to taxes. With municipal bonds, the interest you receive is always tax-free at the federal level, and if you buy bonds issued by your home state, your interest will be exempt from state and local taxes, too. If you're already hovering around the top of a particular tax bracket, taxable bond income could push you over the edge into a higher bracket overall. When you buy munis, you don't have to worry about that. You get to keep all of the interest you earn as income without having to fork over a percentage to the good folks at the IRS.

Let's say your effective tax rate is 25%, and you buy bonds paying $400 in annual interest. If those bonds are munis, you'll get to keep the full $400, whereas with corporate bonds, you'd only get to hang on to $300.

2. Historically low default ratesThough bonds are considered much less risky than stocks, there's always the risk that an issuer will default on an interest or principal payment. Still, history tells us that municipal bonds are 50 to 100 times less likely to default than corporate bonds with the same ratings. Furthermore, there has never been a default on a muni bond rated "AAA"(the highest rating S&P will give out). This means municipal bonds are a fairly safe investment in the grand scheme of fixed-income securities. Assuming your bonds don't default, you'll get to sit back and collect your interest payments every six months -- and you can then reinvest those payments to earn even more money.

3. You may profit in more ways than oneSome people like municipal bonds because they offer the chance to invest locally. And you don't have to be the new-age hippie type to appreciate the notion of funding a local project that might benefit you in ways that aren't just financial. For example, say your town issues bonds specifically to fund an expansion of a local highway that's always congested. By purchasing these muni bonds, you could enjoy a steady stream of incomeandhelp to make your daily commute easier.If you're a property owner, here's an even better reason to put some money into local munis: If those bonds are used to improve your neighborhood, then you might see your own property value go up.

Of course, breaking into the world of muni bonds can be a bit intimidating if you're new to the game, but thankfully, the Municipal Securities Rulemaking Board's website is loaded with information to help you get started. Another option, if you're less inclined to put money into individual bonds, is to consider a municipal bond EFT. ETFs, or exchange-traded funds, are funds that trade like stocks but offer exposure to a basket of investments. Municipal bond ETFs offer the same federal tax advantages as individual muni bonds, but because they trade on an exchange, they're far more liquid. They also offer the added benefit of diversification, because they invest you in multiple bonds instead of a single issue. Both the iShares National Muni Bond ETF and SPDR Nuveen Barclays Municipal Bond ETF have low expense ratios and are good starting points if you're looking to break in.

Of course, as is the case with all investments, municipal bonds have their drawbacks. In exchange for taking on less risk, you may see a lower return on investment than you would with corporate bonds, and you're extremely likely to make less money than you would with stocks. But if you're looking for a reasonably safe place to put a portion of your money, municipal bonds are a pretty good bet.